Most economists would agree with Krugman that the renminbi is probably undervalued. But the extent of misalignment remains a controversial subject. For instance, applying a purchasing power parity approach, Menzie Chinn of University of Wisconsin at Madison and his collaborators estimated an undervaluation of about 40%. But after the World Bank’s 40% downward revision of Chinese GDP in PPP terms, that undervaluation disappeared completely. Nick Lardy and Morris Goldstein of the Peterson Institute of International Economics suggested that the renminbi was probably only undervalued by 12-16% at the end of 2008. My colleague Yang Yao and his collaborator at the Peking University found even less misalignment.
The renminbi exchange rate is but one, and perhaps not even the most important, factor behind China’s large trade and current account surpluses. Among other factors, economic studies have attributed the recent surge in China’s external imbalances to the unique population dividend and the relocation of industries from other Asian economies. My own research has also highlighted the importance of distortions in domestic factor markets, which were largely legacies of the pre-reform economic systems of central planning.
To resolve the global imbalance problem, China, the US, and other countries will need to work together and adopt more comprehensive reform packages, focusing not only on the exchange rate regime but also on domestic structural reforms in their respective countries. Exclusive focus on the renminbi exchange rate issue is likely to be both ineffective and counter-productive. Between mid-2005 and mid-2008, the renminbi appreciated by 22% against the dollar and by 16% in real effective terms. But China’s external imbalances continued to widen rapidly.
The US started to lose manufacturing jobs way before China emerged as a global manufacturing centre. China’s current account surplus increased after 2004. But America’s current account deficits mushroomed from around the turn of the century. There is no denying that China and the US should work together to resolve the imbalance problem. But to say that China’s surplus caused America’s deficits, which emerged much earlier, is simply at odds with common sense.
So what would happen were the Obama administration to follow Krugman’s advice?